Types, Risks, Yields and Words from our Expert

In a volatile stock market, more and more investors are turning to bonds as an alternative investment. But like any investment, bonds have risks, and it's important for investors to understand exactly how they work before putting money in them.

Bonds are essentially loans that pay back principal plus interest. If you loan the government, for example, a sum of $10,000 for the next 10 years, you will be paid interest, and your $10,000 will be paid back at the bond's maturity. The higher the interest rate, the more money you make. Thus, when prevailing interest rates are higher, bonds tend to do very well, but when interest rates are low, the investment is less attractive. In a rising interest rate environment, bonds that are purchased and then sold in the secondary market tend to lose value. Issuer risk is also a potential concern in any market.

Mike Shamia, Scottrade Fixed Income Manager, provides some insight into the different bond options available:

Treasury Bonds

What They Are: Treasuries are sold in denominations of $1,000 and are backed by the full faith and credit of the U.S. government. They are state and local tax exempt. Examples of treasuries are Treasury Bills with maturities ranging from a few days to 52 weeks; Treasury Notes maturing in two, three five, seven and 10 years; Treasury Inflation-Protected Securities (TIPS) maturing in five, 10 and 20 years; and Treasury Bonds that mature in 30 years.

Who Buys Them: Treasury bonds generally appeal to conservative investors because they are fully backed by the federal government.

Risk vs. Yield: Because the risk is lower, the yield is also lower. These bonds are usually more attractive for their security than their payout.

Mike's Thoughts: Because treasuries come in different varieties with varying maturities, they work well with a laddering strategy. This means investors carry bonds with different interest rates and staggered maturities to decrease interest rate and re-investment risk.

Agency Bonds

What They Are: Agency bonds are issued by organizations related to the U.S. government, but they do not have explicit government backing. Bonds are generally issued backed by mortgages or loans. Examples of agencies that issue bonds are the Government National Mortgage Association (Ginnie Mae), Federal National Mortgage Association (Fannie Mae), Federal Home Mortgage Corporation (Freddie Mac) and Student Loan Marketing Association (Sallie Mae).

Who Buys Them: Agency bonds appeal to all types of investors because they are more middle-of-the-road when it comes to risk and yield. The agencies' ties to the U.S. government and the backing that relationship implies also makes agency bonds more attractive.

Risk vs. Yield: The risk with agency bonds is greater than that of treasuries, but the yield can also be potentially greater. Risks include possible changes in legislation that may affect the status of the issuer. There is also liquidity risk involved with agency bonds that is not evident in the highly liquid treasury market.

Mike's Thoughts: When a few of these agencies were nationalized in 2008, they became essentially owned by the U.S. government. Since that time, these bonds have become even more attractive, often trading at a premium, because of the additional implied security. There is still an underlying risk of the unknown in this volatile and fluid legislative environment. It is important to do your homework and understand exactly what you are buying.

Municipal Bonds

What They Are: Local governments, airports, hospitals and school districts issue municipal bonds to raise money for improvements and to finance their works and facilities. Municipal bonds are federal tax exempt and may also be exempt from state and local taxes.

Who Buys Them: Municipal bonds offer strategic tax advantages, so they are generally owned by higher net-worth individuals. They vary widely in type and often appeal to a more experienced set of investors.

Risk vs. Yield: Yield is generally higher than treasuries. Risk is slightly higher than treasuries or agency bonds. But, the tax advantages offer a distinct value to many investors and can offset the lower yields and higher risk.

Mike's Thoughts: An intangible advantage of municipal bonds is that you can invest in your own community, help fund the parks and community centers you use, and have a stake in your local assets. Plus, you can recoup some of the property taxes you pay. There is a distinct liquidity risk involved in owning municipal bonds, which in most cases trade far less than other types of bonds. Many municipal bonds are insured, so it is important to look into not only the health of the issuer but also the viability of the insuring party.

Corporate Bonds

What They Are: Much like governments and municipalities issue bonds to raise capital for operating costs, corporations can do the same thing. Corporate bonds can be convertible, meaning they can be converted into common stock, and/or callable, meaning the issuing company can call them back at a specific time or price, usually when interest rates become less favorable. Corporate bonds also rank ahead of preferred and common equity in case of bankruptcy.

Who Buys Them: Corporate bonds can be attractive to investors who are used to owning equities because they require the same degree of faith in a company's operations. These bonds are solely backed by the health of the issuing company.

Risk vs. Yield: Corporate bonds are generally the highest yielding bonds because they have the greatest level of risk. Investment-grade corporate bonds often have lower yields, but are issued by healthy companies with good credit quality. High-yield corporate bonds are usually issued by less healthy companies with lower credit quality and are often referred to as junk bonds.

Mike's Thoughts: The most important thing to do when considering corporate bonds is research. Just like you would when considering a stock purchase, you should make sure you understand what the company does and have faith in its management to make good decisions with your money.

Bond Research

Mike Shamia recommends four ways for Scottrade customers to research any bond from any issuer before buying:

1. Log in to your account on www.scottrade.com. Click the Trade tab, and choose CDs & Bonds from the left-hand menu. A series of menus along the top will help you find all the information you need about a particular bond or bonds in general.

2. Call your local branch office. If you're considering a particular bond and have questions about it or its particular tax exempt benefits, your local broker will be able to get you all the information you need.

3. Visit the Financial Industry Regulatory Authority at www.finra.org. FINRA can provide detailed information about bonds for investors.

4. Visit the Securities Industry and Financial Markets Association (SIFMA) Web site dedicated to educating investors on bonds at www.investinginbonds.com.